Commitments and Contingencies

Lease Obligations

The Company leases office space and certain equipment under non-cancelable lease agreements.

Prior to January 1, 2019, the Company applied the accounting guidance in ASC 840, Leases, to its lease agreements. The leases were reviewed for classification as operating or capital leases. For operating leases, rent was recognized on a straight-line basis over the lease period. For capital leases, the Company recorded the leased asset with a corresponding liability and amortized the asset over the lease term. Payments were recorded as reductions to the liability with an appropriate interest charge recorded based on the then-outstanding remaining liability.

The Company considered the nature of the renovations and the Company’s involvement during the construction period of previously leased office space to determine if it was considered to be the owner of the construction project during the construction period. If the Company determined that it was the owner of the construction project, it was required to capitalize the fair value of the building as well as the construction costs incurred, including capitalized interest, on its consolidated balance sheet along with a corresponding financing liability (“build-to-suit accounting”). Upon completion of the construction of the facility under a build-to-suit lease, the Company assessed whether the circumstances qualified for sales recognition under the sale-leaseback accounting guidance. If the lease met the sale-leaseback criteria, the Company would remove the asset and related financial obligation from the balance sheet and evaluate the lease for treatment as a capital or operating lease. If upon completion of construction, the project did not meet the sale-leaseback criteria, the leased property was treated as an asset financing for financial reporting purposes. The portion of the facility financing obligation representing the principal that was to be repaid in the following 12 months was classified as a current liability in the consolidated balance sheets, with the remaining portion of the obligation classified as a noncurrent liability.

Beginning January 1, 2019, the Company applies the accounting guidance in ASC 842, Leases. As such, the Company assesses all arrangements, that convey the right to control the use of property, plant and equipment, at inception, to determine if it is, or contains, a lease based on the unique facts and circumstances present in that arrangement. For those leases identified, the Company determines the lease classification, recognition, and measurement at the lease commencement date. For arrangements that contain a lease the Company: (i) identifies lease and non-lease components; (ii) determines the consideration in the contract; (iii) determines whether the lease is an operating or financing lease; and (iv) recognizes lease ROU assets and corresponding lease liabilities. Lease liabilities are recorded based on the present value of lease payments over the expected lease term. The corresponding ROU asset is measured from the initial lease liability, adjusted by (i) accrued or prepaid rents; (ii) remaining unamortized initial direct costs and lease incentives; and (iii) any impairments of the ROU asset. The interest rate implicit in the Company’s lease contracts is typically not readily determinable and as such, the Company uses its incremental borrowing rate based on the information available at the lease commencement date, which represents an internally developed rate that would be incurred to borrow, on a collateralized basis, over a similar term, an amount equal to the lease payments in a similar economic environment. The weighted average discount rate utilized on the Company’s operating lease liabilities as of December 31, 2019 was 9.85%. The weighted average remaining lease term for the Company’s operating leases as of December 31, 2019 was 6.50 years.

Primary Facility Lease

In August 2015, the Company entered into a lease agreement for approximately 51,000 rentable square feet of facility space in Morrisville, North Carolina, commencing in April 2016 (the “Primary Facility Lease”). The initial term of the Primary Facility Lease extends through June 30, 2026. The Company has an option to extend the Primary Facility Lease by five years upon completion of the initial lease term, however, the renewal period was not included in the calculation of the lease obligation. Current contractual base rent payments are $95 per month, subject to a three percent increase annually over the term of the Primary Facility Lease.

Prior to January 1, 2019, the Company applied the accounting guidance in ASC 840. Based on that guidance, the facility was accounted for as an asset financing, with the building asset and related facility financing obligation remaining on the Company’s balance sheet. The building asset was being depreciated over a 25 year period and the facility financing obligation was amortized so that the net carrying value of the building asset and the facility financing obligation were to be equivalent at the end of the initial term of the lease agreement. Monthly rental payments were allocated between principal and interest expense associated with the facility financing obligation, as well as grounds rent expense of $8 per month.

The Company had recorded an asset related to the building and construction costs within property and equipment of $10,557 as of December 31, 2018. The non-current facility lease obligation on the Company’s consolidated balance sheet was $7,998 as of December 31, 2018. During the year ended December 31, 2018, the Company recognized interest expense related to the primary facility lease of $1,044 and there was $41 of accrued interest included in other accrued expenses as of December 31, 2018

The Company adopted Topic 842 as of January 1, 2019 using the modified retrospective transition method and initially applied the transition provisions as of January 1, 2019. This transition method allowed the Company to continue to apply the legacy guidance in ASC 840 for periods prior to 2019 and recognize a cumulative-effect adjustment to the opening balance of accumulated deficit as of the date of adoption.

The Company elected the package of transition practical expedients, which, among other things, allowed the Company to keep the historical lease classifications and not have to reassess the lease classification for any existing leases as of the date of adoption. The Company also made an accounting policy election to apply the short-term lease exception, which allows the Company to exclude leases with an initial term of twelve months or less from the consolidated balance sheets.

As a result of the adoption of Topic 842, the Company derecognized $10,557 of building asset (property, plant and equipment), and $7,998 of facility financing obligation associated with previously existing build-to-suit arrangement related to its sole corporate and manufacturing facility. The Company also capitalized leasehold improvements and ROU assets of $5,885 and $1,827, respectively, and recorded lease liabilities for operating leases totaling $6,786, as of January 1, 2019. The capitalized leasehold improvement assets recorded as part of the adoption of Topic 842 were previously included within the derecognized building asset as part of the previous build-to-suit arrangement. The Company also recognized an increase of $714 to accumulated deficit related to its de-recognition of its previously recorded build-to-suit arrangement.

The Company has elected to separate lease components (fixed rent payments) with non-lease components (common-area maintenance costs) on its real estate assets. Fixed lease payments on operating leases are recognized over the expected term of the lease on a straight-line basis. Variable lease expenses that are not considered fixed are expensed as incurred. Fixed and variable lease expense on operating leases is recognized within operating expenses within our consolidated statements of operations. The Company has elected the short-term lease exemption and, therefore, does not recognize a ROU asset or corresponding liability for lease arrangements with an original term of 12 months or less.

Rent expense, including both short-term and variable lease components associated with the primary facility lease, was $880 and $308 for the years ended December 31, 2019 and 2018, respectively.

The Company’s supplemental non-cash disclosure for its ROU assets obtained in exchange for lease liabilities was $1,827 for the year ended December 31, 2019.

At December 31, 2019, maturities of operating lease liabilities over each of the next five years and thereafter are as follows:



	Operating Leases
2020	$	1,215
2021	1,241
2022	1,278
2023	1,317
2024	1,356
Thereafter	2,111
Total minimum lease payments	$	8,518
Less imputed interest	$	(2,256	)
Total lease liability	$	6,262

Primary Facility Sublease

In July 2018, the Company and a third-party tenant commenced a sublease of approximately 6,400 square feet of office space at the Company’s headquarters. The sublease has a three-year, non-cancellable term and provides for monthly rental income to the Company of approximately $12 per month through July 2021. The Company has classified the sublease as an operating lease pursuant to classification criteria in ASC 842 and is recognizing the rental income on a straight-line basis over the lease term as a component of other income and expense in the Company’s consolidated statements of operations and comprehensive loss. In October 2019, the Company executed a termination agreement with the subtenant for this sublease, with an effective date of December 31, 2019.

Contingencies

From time to time, the Company may have certain contingent liabilities that arise in the ordinary course of business activities. The Company accrues a liability for such matters when it is probable that future expenditures will be made and such expenditures can be reasonably estimated. See Legal Proceedings below for further discussion of pending legal claims.

The Company has entered into, and expects to continue to enter into, contracts in the normal course of business with various third parties who support its clinical trials, preclinical research studies and other services related to its development activities. The scope of the services under these agreements can generally be modified at any time, and these agreements can generally be terminated by either party after a period of notice and receipt of written notice. There have been no material contract terminations as of December 31, 2019.

See Note 4—Research and Development Licenses regarding the Company’s research and development license agreements.

See Note 7—Research and Development Arrangements regarding the Purchase Agreement with Reedy Creek and the Funding Agreement with Ligand.

Legal Proceedings

In prior filings, the Company reported that it was subject to putative stockholder class action lawsuits that were filed in November 2017 in the United States District Court for the Middle District of North Carolina against the Company and certain of its current and former directors and officers, which were consolidated under the case name In re Novan, Inc. Securities Litigation. The consolidated amended complaint filed by the designated lead plaintiff asserted claims for violation of Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Exchange Act and SEC Rule 10b-5 promulgated thereunder, in connection with statements related to the Company’s Phase 3 clinical trials of SB204. On June 14, 2018, the Company filed a motion to dismiss the consolidated amended complaint. On November 30, 2018, a federal magistrate judge entered an order recommending that the district court grant the Company’s motion. The plaintiff filed objections to this recommendation and the Company filed a response. On January 28, 2019, the district court adopted the magistrate judge’s recommendation, dismissed the action with prejudice and entered judgment in favor of the Company and against the plaintiff. The plaintiff did not appeal this dismissal and judgment. As such, the Company has concluded that this matter is closed.

Other than as described above, the Company is not currently a party to any material legal proceedings and is not aware of any claims or actions pending or threatened against the Company that the Company believes could have a material adverse effect on the Company’s business, operating results, cash flows or financial statements. In the future, the Company might from time to time become involved in litigation relating to claims arising from its ordinary course of business.

Compensatory Obligations

In conjunction with the departures of three former Company officers in 2019 and 2018, the Company entered into separation and general release agreements that included separation benefits consistent with the Company’s obligations under their previously existing employment agreements for “separation from service” for “good reason.” The Company recognized related severance expense of $878 and $332 during the years ended December 31, 2019 and 2018, respectively. The remaining accrued severance obligation in respect of the three former officers was $33 as of December 31, 2019, which is included in accrued compensation in the accompanying consolidated balance sheet. The Company also recognized non-cash stock compensation expense of $212 during the year ended December 31, 2018, respectively, related to the accelerated vesting of the former officers’ stock options. There was no non-cash stock compensation expense in relation to these departures during the year ended December 31, 2019.

In November 2018, the Company realigned its overall employee headcount to reduce certain fixed costs. The Company recognized related severance expense of $67 and $196 during the years ended December 31, 2019 and 2018, respectively. As of December 31, 2019, severance costs of $52 were accrued in the accompanying consolidated balance sheet.

See Note 11—Share-Based Compensation regarding the SARs granted in August 2018.

See Note 12—Tangible Stockholder Return Plan regarding the Tangible Stockholder Return Plan adopted in August 2018.